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Flawed Models or Misused Models The Role of Modeling in the Mortgage Meltdown Basic Modeling Tenets Use it Appropriately Validate It Properly Stress It Understand it and Explain it Simplify It Structure of Practical Mortgage Modeling

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Flawed Models or Misused Models

The Role of Modeling in the Mortgage Meltdown


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Basic Modeling Tenets

  • Use it Appropriately

  • Validate It Properly

  • Stress It

  • Understand it and Explain it

  • Simplify It


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Structure of Practical Mortgage Modeling

  • A environment (Ei) that represents the exogenous variables to the mortgage/mortgage holder

  • An nth order inhomogeneous Markov chains (Xn) which describes the monthly evolution of the borrower’s mortgage status on the state space S.

  • A cash flow vector (CFn) that represents the payment cash flows from each path of the Markov Chains


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Exogenous Environment

  • A sequence of monthly projections to allow valuation, stress testing and analysis.


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State Space

  • Choice of State Space based upon collateral type and use:

State Space A: Three States, Two terminating

State Space B: Form Loan Performance Technical Paper: 9 states, 2 terminating


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Transition Probabilities

Combinations of Environmental variables (interest rates, HPI) and borrower variables (FICO, LTV, etc.)

  • Historical Roll Rates – Still Very Common

  • Single Logistic Regressions

  • Multinomial Logit Models:

    • CPRi,t = exp ( x(i, t)’ p )/ A and

    • CDRi,t = exp ( x(i, t)’ d )/ A

    • where A = 1 + exp ( x(i, t)’ p ) + exp ( x(i, t)’ d )

    • x(i,t) independent variables: age, seasonality, refi function, FICO score

  • Custom Functions


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Prepayment

  • P(Xn+1=Prepayment | Xn = Current, etc) = SMMi

  • SMMi = Refinancing Activity + Housing Turnover

    • Refinancing Activity usually consists of

      • Refinancing incentive

      • Seasoning

      • Seasonality

      • Burnout

      • Media Effect

        Refinancing Activity = burnout * seasoningi * seasonalityt*refin,t* Media Effect


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Refinance: S Curve

1

Ratio of C/R

Where C mortgage rate

R is market rate.

0




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Five Model Qualities

  • Correct Usage:

    • Payment Option ARMs:

  • Validate It Properly:

  • Stress It

  • Understand it:

  • Simplify It:


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